The fiscal stimulus has been timely and adequate, but its mainly permanent nature has weakened long–term sustainability

Finland came into the recession with a significant budget surplus, a strong net asset position and a pension system that seemed geared to deal with ageing. Due to strong automatic stabilisers and stimulus, the fiscal position has deteriorated more rapidly than in any other OECD country, and the surplus of 5.2% of GDP in 2007 is projected to swing to a similarly large deficit in 2011. The fiscal stimulus was introduced in several steps as the recession worsened amounting to 1.8% of GDP in 2009 and a further 1.5% of GDP in 2010. The thrust of the stimulus has been on tax cuts, primarily focused on lower income brackets, but social security contributions have also been reduced. Additional resources have been channelled towards unemployment support and municipalities. The fiscal stimulus, together with sharply lower interest rates, has cushioned the downturn.

Although the overall size of the fiscal stimulus implemented in Finland during the crisis is similar to the OECD average, it is distinguished by its mainly permanent nature. A significant part of the stimulus consists of permanent tax cuts announced in the 2007 government programme, which were timed on cyclical grounds and implemented in 2009. Only one third of the stimulus was of a one–off nature or for a limited period. The government has so far only announced some consolidation measures and the exit strategy is still to be formulated. The open–ended fiscal stimulus contributes to pre–existing, significant long–term fiscal challenges. Even before the recession, unfavourable demographics implied an unsustainable fiscal position in the long run. The subsequent losses to potential output and the fiscal stimulus have contributed to a further deterioration. The so–called sustainability gap, which shows the permanent fiscal consolidation needed to cover future fiscal obligations, is estimated to have risen to almost 8% of GDP.

A consolidation plan supported by revised fiscal rules should be announced soon and implemented once the recovery is established

To restore sustainability Finland will need to show the same fiscal resolve as it did following the 1990s crisis. While it would be premature to start fiscal consolidation now, the government should urgently develop, communicate and be ready to implement a sustainability plan. Such a plan should mainly rely on significant increases in the length of working lives and lower government expenditures, but higher taxes are also likely to be needed. Due to compounding, the hurdle will increase significantly for every year without consolidation and will add to the burdens of future generations. Consolidation should start once the recovery firms.

Fiscal sustainability requires extensive consolidation

Source: OECD, Economic Outlook 86 database and OECD calculations.

Finland’s fiscal framework has been useful but it should be reviewed and strengthened to support consolidation. The recession led to the breach of both of the fiscal surplus targets, but the expenditure ceiling remains intact and central government spending has remained within these limits. As in most other countries in the European Union, the deficit is projected to exceed the 3% of GDP limit stipulated by the Stability and Growth Pact. To support consolidation and sustainability the government should consider setting rolling multi–year targets for the structural balance that are explicitly calibrated to achieve sustainable public finances in the long run. Given the size of the unfunded longer term fiscal obligations, the government should aim to close the sustainability gap over the next two four–year electoral mandate periods.

Fiscal sustainability issues are by their nature complex and entail important trade–offs. Finland could, therefore, consider establishing an independent fiscal council, to provide more information to the public and policy makers, and to evaluate whether fiscal policy is in line with the government’s targets. This would encourage a wider discussion on and evaluation of fiscal policy and its sustainability. It would also provide support and justification for fiscal consolidation.

Closing the gap may need tax increases, which should focus on broadening tax bases and raising property taxes

The 2007 Government Programme aimed at lowering taxation, especially on labour. As a result, sizeable tax cuts were implemented during the recession. While the goal of lowering the tax burden on labour to encourage further labour supply is laudable, the potential supply side effects of the tax cuts are being undermined by accompanying reductions in taxes on income transfers and tax hikes in the municipal sector. Thus incentives to work may not have been increased substantially by these reforms.

The size of the sustainability gap means that tax increases probably will be needed to rectify the fiscal position. On a general level, the government should endeavour to broaden tax bases and raise beneficial taxes, while holding off from raising them on corporations or labour. The recent cut of the value–added tax (VAT) on foodstuffs, which will be broadened to include restaurants, is a step in the wrong direction as it lowers efficiency in the VAT system. The announced increase in the overall VAT rate for 2010 should eventually be accompanied by a full harmonisation of the VAT at this higher level. This needs to be accompanied by targeted compensation for low income earners.

There is room for further increases in property taxes, which in Finland are well below the OECD average. Property taxes tend to be less harmful for growth than other taxes, and have benign distributional effects. Property taxation in Finland is to a large extent decided by the municipalities. The government should encourage a shift towards more reliance on property taxes and less on income taxes in municipalities. The current process to harmonise the assessment of property values to market levels is welcome. Further increases in the lower bound and an abolition of the upper bound for property taxes are necessary. Taxation of agricultural and forest land should be considered. Such tax increases should be implemented gradually and may need to be accompanied by changes in the transfer system to municipalities.

Consolidation would be assisted by fine–tuning environmental initiatives including energy taxation and subsidies

Finland is taking seriously its commitments to climate change abatement. In 2009 the government adopted a report on long–term climate and energy policy that extended its climate and energy strategy from the 2020 EU targets to 2050. As part of this effort, the government announced new environmental taxes for 2010. However, further progress is required in a number of areas, as Finland is one of the few countries in Europe that has not decreased its greenhouse gas emission intensity of energy consumption since 2000. While the government´s commitment to the 80% emission reduction target of the 2050 report is welcome, Finland continues to subsidise peat in energy generation on regional development grounds, despite the very high cost in terms of emissions. The government should formally commit to the targets of the 2050 report, and abolish preferential treatment of peat. An environmental levy on peat should be considered. Other weaknesses in Finland’s energy taxation are the tax refund system for certain energy–intensive industries, including for the agriculture sector. If the objective of these subsidies is to maintain regional employment, this would be better addressed via direct employment subsidies.

Consolidation should focus on containing expenditure growth, especially in municipalities

General government spending has been growing fast, mainly due to fast–growing municipal spending fuelled by buoyant revenues. The government needs to constrain municipal expenditure growth by limiting the rise in state transfers to local governments and by removing the incentives to increase municipal income taxes, e.g. through partially offsetting tax increases with lower state transfers. Ways to decrease the municipalities’ dependency on highly–cyclical corporate tax revenues should also be explored.

The central government expenditure ceiling has been observed and should be strengthened further. The exclusion of cyclical outlays from the ceiling is useful as it ensures that automatic stabilisers can work fully. As there will be little room for raising the ceiling in the coming years, and margins under the ceiling are already thin, the government should boost surveillance to ensure that expenditure programmes do not slip outside the ceiling either through reclassification as cyclical outlays, shifting to local governments, or as tax expenditure. The government’s recent decision on improving methods of measuring and reporting tax expenditures is thus welcome.

Municipal mergers should be stepped up to reverse the decline in efficiency in service provision

Productivity in local government–provided services fell by more than 10% between 2000 and 2008 on the back of strongly growing municipal expenditures. The decentralised fiscal structure and the soft budget constraints faced by local governments have contributed to this development. The increasing inefficiencies should be addressed. While stagnating or shrinking revenues will spur efforts to achieve productivity gains, structural reforms are also necessary.

Programmes to increase efficiency in local governments include incentives for mergers, for investment in information technology and the establishment of minimum population–base requirements for school and healthcare districts. During the last few years, there have been considerable efforts in terms of mergers, with the number of municipalities shrinking from 431 in 2008 to 348 in 2009. Still, their average population is 13 000, with the median below 5 000. Moreover, the mergers have not yet produced substantial productivity gains, which can partly be explained by the fact that participating municipalities typically agree not to adjust the workforce for an extended period following a merger. Many small municipalities are struggling fiscally with high dependency on state transfers. As the general population ages, and the working–age population migrates towards large centres, many small municipalities will become even less fiscally sustainable. A more ambitious programme of municipal reforms should be pursued. While the recent municipal mergers in Denmark may serve as a model, geographical and other factors particular to Finland need also to be considered.

To improve efficiency in municipal service provision, the strategy for mergers needs to be accompanied by rationalisation in local governance to reap plant–level economies of scale in health care, education and childcare. While relying on competition to improve efficiency in service provision in small municipalities may be difficult due to the thinness of the market, there is clearly more scope for competition in larger municipalities. Finding cost–efficient and yet equitable ways of providing municipal services will be a challenge, and the government needs to continue to support research on and knowledge–dissemination of best practices among them.

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